When Markets Drop, Turn Your Useless Emotions Into Useful Drudge Work

With the stock market dropping significantly over the last two trading days – and probably your brokerage account balance with it – I would like to talk about how useless emotions are in helping you handle drops like this.

First, let’s remember that if this depressive period of the last two days is abnormal, so is the manic period of the last 12 months. Benjamin Graham wrote about Mr. Market as a sort of business partner with mood swings who would offer you very different prices on the very same business depending on what mood he was in. Last year, Mr. Market kept valuing most businesses higher and higher. In the last two days, he keeps valuing them lower and lower.

Both periods are abnormal, but one is not more abnormal than the other. The way humans think tends to cause us to view the last two trading days as the oddity and the last year or so as something fairly normal. Both periods were extremely odd. And it is probably not random chance that a couple very volatile days followed an incredible streak of very non-volatile months. Why, then, do many smooth months feel more normal than a couple rocky days?

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This is a pattern you will see again and again. People do not like to think of a Shiller price-earnings ratio of 16 or an EV/EBITDA of 8 or whatever as “normal”. What they like to think of as normal is whatever level they have seen for a few years in a row. I have talked about this before, especially with the Federal Funds Rate and oil prices. I own a stock that would benefit quite a bit from a higher rate.

When I bought the stock a couple years ago, one of the reasons for me buying it was that the Fed Funds Rate was likely to be a lot higher in five years (when, hopefully, I’d be selling the stock) than it was back (at 0% to 0.25%) when I bought it. You wouldn’t think that was a controversial claim, but a lot of investors had gotten used to a really low rate. The report on my Focused Compounding site that discusses a 3% Fed Funds Rate when making all these calculations of intrinsic value got a lot of feedback from readers, where they said: “Do you really think the Fed Funds Rate will get back to 3%?”.

Now, of course, the Fed Funds Rate is nowhere near 3%. And maybe it will not ever get there. But I figured it would eventually get there and the people betting it would stay closer to 0% than 3% even five years from now were basing that bet intuitively on just one thing: it had been at 0% for the last five years or more. In other words, people got used to that 0% level.

Given enough time, investors will feel the now is normal – regardless of how historically unusual the “now” is. You can see this with the price drop of the past several days. It feels wrong that prices should drop so much, so fast. But does it feel more wrong than the market trading at a Shiller price-earnings of 30 or higher? The market is still at such a high level after the drop. A lot of investors have gotten used to these incredibly high stock prices because they have come about gradually. A big price drop feels wrong, at first. But people learn to accept much lower prices as normal after months of declines. We should be careful. We need to remember the “normal” scenario is for stocks to be about 40% lower in price than where they are right now. It doesn’t feel that way. The idea of a 40% decline in stocks seems outlandish, but a Shiller price-earnings of 30 or higher is outlandish. So we are already living in outlandish territory. It is just that getting there through years and years of strong stock market gains that outstrip earnings feels normal because it is so gradual and we are now so used to it. Sudden declines do not feel normal because we have not had time to get used to them. That’s sort of the definition of “sudden”: something happening so fast you’re not used to it yet.

In the long run, though, valuations are destiny when it comes to stocks. Stocks are unlikely to perform well from here, not for any economic or technical reason, but simply because they are clearly too expensive. It’s boring to keep harping on something like the Shiller price-earnings ratio, but that’s what will determine your long-term returns much more so than what happens over a few trading days – however dramatic they’ve been.

Should you sell now?

I imagine the urge to sell comes pretty easily to most investors reading this right now. Why? Because your stocks are in the green – not for the last couple of trading days, but since you bought them.

Right?

Go look at your unrealized gains and losses in your brokerage account. I bet you do not see a lot of red. There are not a lot of unrealized losses in there. Rather, there are a lot of unrealized gains. People are usually pretty quick to take gains in stocks that are up since they bought them and pretty slow to take losses in stocks that are down since they bought them.

I think that’s dumb. But I know from experience - and from talking with a lot of otherwise really intelligent investors – that this is one of the most common irrational activities even value investors engage in. For some reason, if a stock they bought in early 2017 went up 25% last year and has now fallen 8% in the last two days – they’re happy to sell and be done with it. But if a different stock they also bought in early 2017 rose just 4% last year and is also down 8% in the last two days – they are reluctant to sell. It is painful to “lock in” that loss.

Well, there are not many losses to lock in right now. If you are a longer-term holder – an investor, not a trader – you have a brokerage account chock full of unrealized gains. It will feel pretty easy to part with those stocks. The very few (do you have any?) stocks that have unrealized losses are the ones that are tough to sell.

Obviously, that’s irrational.

What’s the rational way to approach trimming your portfolio?

The most rational way is to think in terms of three things: 1) What is the price of each of the stocks you own, 2) What is your appraisal value of each of the stocks you own and 3) What stocks would you own if the stock market stayed open but barred you from trading anything you owned?

In other words, what stock would be the least frightening to see plunge if you couldn’t sell it?

That stock belongs near the bottom of your list of stocks to consider selling.

Then, what stock would be the most frightening to see plunge if you couldn’t sell it?

That stock belongs at the very tippy-top of the list of stocks to consider selling.

Your portfolio should be made up of the businesses you love the most, provided the shares of those businesses are among the cheapest. I own three stocks. And I have to admit they are quite a mix in this regard. I think my largest position is the cheapest. My second-largest position is a business I love and is cheap enough (it’s trading at maybe two-thirds of what I think it’s worth). My smallest position is a business I am quite happy to hold forever but quite unhappy with the market price of (it trades at about 30 times earnings).

I have no intention of selling any of them unitl I find something better to buy.

But that’s me. What if I was willing to sell a stock without having another stock to buy?

Well, then, the last stock I mentioned is the only one worth considering selling. If a business is good enough that you feel comfortable with it and the shares of that business are cheap enough that you feel comfortable owning them – then, stick with them.

Don’t sell any business you like when it’s cheap. If you have to sell something – sell a business you don’t like or a business that isn’t cheap. That sounds obvious, but I’ve known plenty of smart people who talked themselves into selling a cheap business they liked.

Sometimes, something can be “cheap enough” even when you have a pretty big unrealized gain in the stock. The stock I told you I think is only trading for about two-thirds of what it’s worth is actually a $102 stock today that I bought at $48. So when I go into my brokerage account, I see a 100%-plus unrealized gain in that position. Does that large gain tempt me to sell?

It shouldn’t.

Now, if the business was one I didn’t like – I should be tempted to sell pretty quick. And, even if the business is one I like, once it passes my appraisal of what I think it’s worth: I should start entertaining thoughts of selling.

Personally, I plan to be in stocks for life. I got started investing when I was 14 in the late 1990s. I’m 32 now, so I’ve been investing for over half my life now. I hope that when I’m 64, I can look back over the years and say I was as close as possible to 100% invested in stocks as often as possible. For a concentrated stock picker – and since I have over 90% of my portfolio in three stocks, I think I qualify – there is always something to do in good markets and bad.

Yes, I personally believe we are in a bubble. I have said my “appraisal value” for the market as a whole – the S&P 500 – is about 40% lower than today’s (post-selloff) price.

That frightens some people and upsets some others, but I don’t think it should do either. I am not saying you should stay out of stocks. I’m staying in them as best I can. And I’m not making any predictions about when the bubble will burst (two bad days like this can easily be reversed and forgotten in time) or if “the bursting” really will be a decline of 40%.

That kind of thinking doesn’t interest me. Stock picking interests me. And this is where things just got easier.

I don’t have a theory about how bubbles work or how they will pop. To me, the definition of a theory is a “useful operating assumption.” What I mean by that is it doesn’t much matter what the capital-T truth is or how nature works – it matters how you frame the day-to-day work you set out for yourself. If subscribing to a certain theory helps you get work done (get the correct answers), it’s a good theory. If it doesn’t help you get correct answers to your practical day-to-day problems, it’s not a good theory. It might be true – but it’s not useful.

Moving away from the very emotional topic of what is or isn’t true and why and toward the much less emotional topic of how to improve your own practical process of investing is going to make you a much better investor and a much saner person.

On the topic of sanity, I have (just today) read arguments that “prove” computers, the Federal Reserve, a Democratic president or a Republican president are responsible for the sudden drop in stock prices we have seen these last couple days. These are opinions you don’t need in your life. Holding them – correct or not – may make you feel better (and certainly more righteous). But they aren’t going to make you richer. And they aren’t going to make you a saner, calmer, happier human being. Leave those kinds of beliefs to professionals who are paid to have opinions. You are paid to pick stocks.

Now is the time to take Twitter off your phone, swear off message boards, turn off CNBC – and instead crack open a 10-K.

Do you have a watch list? No. Well, do you at least have a list of stocks you’ve analyzed in the past? Probably not an exhaustive one, but I bet you could recreate quite a lot of that list if you tried. Get a yellow pad of paper and a pen. Sit down and try to write the names of every stock you have owned or researched in your life. Then – without looking at stock prices, news or anything else – ask yourself to order those names from the one you know best to the one you know least. This exercise will take you a while, but at the end of that process you will have a list of stocks you know well.

Now, whatever you do – don’t look at their stock prices. Don’t check the EV/EBITDA ratio on the summary page here at GuruFocus.

Instead, take those stocks one at a time from the other side of things. Forget the price. Think only of your “appraisal value.” Try to get through appraising the top five stocks on your list. These are the five businesses you feel you know best. If you really commit to this – which means reading and taking notes on one 10-K a day – you can probably work through all five of your best-known stocks in a week.

Where will the market be trading in a week? Higher? Lower? About the same?

The great thing is none of us have any idea.

So  just focus on those five businesses you think you know best. Focus on the appraisal values you are going to mark down – I want an exact number like $57.43 a share – for each of them. Why an exact number? I want you to take your appraisal value as seriously as the market price. Then, in one week, compare the appraisal value you have for those five stocks to the market price.

If all five market prices are higher than all five appraisal values you wrote down, then – as far as you’re concerned – yes, we are in a bubble. If some of the market prices are lower than the appraisal values, then it doesn’t matter if the market is in a bubble. Your personal watch list is not. There’s something for you to do. There’s something for you to consider buying.

And that’s all that matters.

If you’re reluctant to try this practice of just focusing on the five stocks you know best – ask yourself how much time you suspect you’ll be spending watching TV about the stock market, reading articles, on Twitter, constantly checking the price of your own portfolio, etc. Now imagine if you spent that amount of time appraising the five stocks you know best but don’t yet own.

Which use of your time do you think is more likely to make you richer?

Have the discipline to force yourself to use your time that way. That’s the rational thing to do – especially during irrational times.

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